Municipal Bonds: Understanding the Fundamentals

[Pages:4]Municipal Bonds: Understanding the Fundamentals

Market Commentary

August 2016

RECENT EVENTS IN THE MUNICIPAL MARKET UNDERSCORE the importance of understanding the nuances of municipal bonds. Investors who can discern the fundamental characteristics of municipal bonds will be better equipped to identify risks within this asset class. One characteristic in determining which municipal bonds may be appropriate are the differences between two common repayment pledges: tax-supported bonds and revenue bonds.

The sources of pledged revenue for bond repayment are diverse and often complicated. Broadly speaking, pledged revenues fall into two basic categories: taxes, which support securities such as general obligation (GO), income tax and sales tax bonds, or projectrelated revenues that support revenues bonds. The former tend to be issued by states and local governments and the latter by utilities, transportation agencies, and health care providers. As the chart below shows, new issuance in the municipal market is predominately revenue-backed. Here we focus on general obligation bonds issued by local governments and revenue bonds issued by essential service utilities.

Most New Municipal Bonds are Revenue-Backed

(based on par amount at issuance) Revenue Bonds GO Bonds

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Data source: The Bond Buyer. 2016 data is January through July.

NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

Beth Dougherty

Vice President, Senior Research Analyst Nuveen Asset Management, LLC

Leading the Way in Municipal Bonds

Since 1898, Nuveen has been a pioneer in municipal bonds, helping to build lasting value for investors. This municipal bond heritage is reflected in the way Nuveen Asset Management manages portfolios today.* 118 years of experience 23 credit research analysts $121.5 billion in municipal bond AUM Through ongoing publications, the team is committed to helping investors understand today's pressing issues.

* Nuveen Investments, Inc. traces its history back to 1898. Nuveen's asset management business was established in 1989. Nuveen Asset Management credit research analysts and municipal fixed income assets under management as of 6/30/16.

Municipal Bonds: Understanding the Fundamentals

August 2016

General Obligation Bonds

General obligation (GO) bonds are loans backed by a state or local government's full faith and credit, generally including its authority to levy taxes, most often property taxes. Frequent issuers of GO bonds are states, counties, cities and school districts. For states, this constitutes a pledge of its primary operating fund, or General Fund, receipts. For the local governments, the GO pledge is most commonly a covenant to levy property taxes to repay principal and interest, and therefore, the debt service due on a general obligation bond is supported by property tax collections. Failure to pay a property tax bill can lead to the loss of title to the property, providing a strong incentive for payment of property taxes and thereby making the payment stream for debt service fairly secure.

When a local government issues bonds backed by its pledge of property taxes, the security is often referred to as an ad valorem tax pledge. The ad valorem tax pledge can be limited or unlimited as to the rate applied or the amount collected. If the pledge is unlimited, there are no constraints on the municipality's ability to raise taxes to pay debt service. However, the ability to issue unlimited tax debt often requires voter approval and therefore can be more difficult to issue than limited tax debt. Also, the tax levied for these bonds can only be used to pay debt service. The revenues cannot be used legally for any other purpose. If the tax pledge is limited, the municipality may only increase the property tax up to a certain rate and/ or dollar amount. The issuance of limited tax bonds does not usually require voter approval and, depending on the legal structure, the tax collections may or may not be redirected to other expenditures.

Credit analysis of an issuer's general obligation bonds typically focuses on four key factors: local economy and sociodemographics, health of financial operations, debt profile, and the strength of management of the issuer. GO bonds are typically backed by property taxes, so the health of the local tax base and economy is an important indicator of its ability to support debt repayment. The issuer's financial position provides a picture of what services the local tax base is (or is not) able to support as well as management's effectiveness of working within certain economic and/or political constraints. A municipality's debt profile will reflect how much, or little, debt it is already carrying and its capacity to meet additional borrowing needs. The analysis of management often goes hand in hand with the previous three factors as internal policies and historical practices

regarding economic development, financial operations, and debt issuance reflect strength of management.

Though certainly not exhaustive, some common questions examined as part of the GO analysis are:

Where is the municipality located? What is the size and composition of the tax base? What is the socio-demographic profile of its residents?

How healthy is the employment base? Is there concentration in any given industry or employer?

What is the trend of financial operations? Is this supported by internal policies? Does the municipality retain any financial flexibility or reserves?

How leveraged is the tax base and could it support additional borrowing?

While general obligation bonds represent a very strong pledge, they are not completely free from challenges. Spending and policy agendas are authorized by elected officials such as governors, mayors, city councils, or school board officials. As a result, political pressures can influence budgetary decisions to raise taxes and/or cut costs. Though ad valorem general obligation bonds often benefit from a legally designated debt service levy, there are occasions when this levy is abated and other available revenues are applied to debt service. In this instance, when there are downswings in the economy and those other revenues are no longer sufficient to cover debt service, management will face the decision to raise its overall property tax levy or make other operating cuts to accommodate debt service. As recent debate has shown, both options can be politically challenging.

Essential Service Revenue Bonds

Essential service utilities provide critical services such as water, sewer, and electricity. They are considered essential services due to their importance in maintaining public health and safety, and providing infrastructure that promotes economic growth. The revenues generated by these utilities are primarily user fees, wholesale contracts, connection fees, and investment income. The fees and contracts are set by the utility, though in some states there may be an oversight entity that must approve rate increases, which could limit the ability to raise revenues.

A revenue bond is secured by either a gross revenue pledge or a net revenue pledge, with the latter being more common. A gross revenue pledge promises to pay bondholders prior to any other

2

Municipal Bonds: Understanding the Fundamentals

August 2016

expenditure. Under a net revenue pledge, the utility's operation and maintenance expenditures are paid prior to debt service. As bondholders are ultimately dependent on the system to generate additional revenue for future debt service, it is reasonable that operations and maintenance be paid prior to debt service so that the system remains functional over the long term.

When issuing revenue bonds, the utility makes legal commitments ? known as covenants ? such as the structuring of rates, the order in which revenues will be applied across various expenditures (including debt service), and requirements for issuing additional bonds. The strength of these covenants, the revenue pledged, and the credit characteristics of the issuer are all important factors in determining a bond's creditworthiness. Analyzing these characteristics of an essential service revenue bond is somewhat similar to analyzing a general obligation bond. In the analysis of a revenue bond, we examine the qualities of the customer base and physical infrastructure, health of financial operations, debt portfolio, and quality of management. While the general factors are similar to that of GO bonds, the supporting traits are quite different. Instead of looking at the size and composition of the tax base, the diversity and size of the customer base is examined because it directly affects the strength of billing collections. Notably, the largest customers of the enterprise system, consuming the greatest volume of services, may not be the ones that pay the most. Also, the service area of an essential utility can extend far beyond the boundaries of a municipality and may provide wholesale service to other nearby municipalities.

When examining the ability of a utility to cover its expected debt service, an analyst will consider:

Who are the major users and largest billing accounts? Is there a concentration of industry or any single user? What is the size and growth trend of customer accounts?

How competitive are rates, and does management have the willingness and ability to raise them? How strong are reserves compared to operation and maintenance expense?

What is the ratio of net revenues to annual debt service and maximum annual debt service?

How much debt has the utility taken on, and are there additional capital needs?

Most often, these utilities are legally tied to a local government, like a city water department, making them subject to the same

management that oversees the general municipal operations. In such cases, it is rare that the essential service revenue bond would be considered to be of higher credit quality than the municipality's general obligation pledge, in part because they likely share the same management team. However, on occasion, the revenue bond will be considered the stronger of the two credits. The city of Toledo, Ohio, and its water utility is one such example. Moody's Investors Service has public ratings of A2 on the city's general obligation bonds and Aa3 on the water revenue bonds, indicating that the rating agency likely believes the water revenue bonds to be of higher credit quality.1 Though not specifically identified by the rating agency, reviewing the two reports reveals three important points:

The water utility's service base extends far beyond the city. Toledo's customer base accounts for only 59% of water consumption; remaining demand is from customers in three Ohio counties and another in Michigan.

The water utility's financial operations appear to be in better shape than the city's general operating funds. Moody's describes the city's General Fund as "challenged."

The utility is a closed loop system so it is protected from the city raiding its funds.

A major limitation of essential service revenue bonds is that revenues are dependent on what the utility can generate through user and other fees. There is no taxing authority to back the bonds. Also, revenues and expenditures can be volatile due to weather events, slowdown in development resulting in lower connection fee revenues, or a change in supply costs. Adjusting rates mid-year to increase revenues is not always possible as rates in some states must be approved by another agency or regulatory body. Like property taxes, increases in utility rates can also be politically challenging due to their essential nature.

Conclusion

As investment opportunities, general obligation and revenue bonds each provide relative value and risk. Understanding the basic differences of these bonds can provide a solid foundation upon which to build an appropriate strategy for an investor considering municipal bonds. The key to balancing these securities within an investor's portfolio is to understand their investment goals and support those goals with fundamental credit research.

3

Municipal Bonds: Understanding the Fundamentals

August 2016

GPE-UNDMB-0816P18812-INV-AN-08/17

For more information, please consult with your financial advisor and visit .

1 Moody's Investors Service: New Issue Report, City of Toledo (OH), September 16, 2015. Moody's Investors Service: New Issue Report, City of Toledo (OH) Water Enterprise, August 8, 2016.

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any investments or related securities. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Research. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes.

The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. An investment in any municipal portfolio should be made with an understanding of the risks involved in investing in municipal bonds. There are risks inherent in any investment including the possible loss of principal. Bonds and other fixed-income investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due. The value of the portfolio will

fluctuate based on the value of the underlying securities. This information should not replace an investor's consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact their tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer.

CFA? and Chartered Financial Analyst ? are registered trademarks owned by CFA Institute.

Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc. ? 2016 Nuveen Investments, Inc. All rights reserved.

Nuveen|333 West Wacker Drive|Chicago, IL 60606|800.752.8700|

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download